Solow Growth Model

October 9, 2019

1 The Solow Growth Model

• The Solow Model is one of exogenous growth
• Sustained increases in the standard of living can occur in this model, but sustained techno-
logical advancements are necessary for this
Consumers
• Separate time into current and future periods
• Suppose population grows exogenously N is the labor force/employment (no unemployment).
Population grows over time:

N 0 = (1 + n) N (1)
where N 0 is the population in the future period and n > −1
• In each period, consumer has 1 unit of time available
 Assume they do not value leisure so they supply their 1 unit
• Consumers collectively receive all current real output Y as income because there is no gov-
ernment/taxation
• Assume consumers consume a constant fraction of input each period

C = (1 − s) Y (2)

where C is current consumption

• For consumers,

C +S =Y

where S is aggregate savings

Therefore,

S = sY (3)

and s is the aggregate savings rate1

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We will leave the question of how consumers make their savings decisions in Chapters 9 and 10

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The Representative Firm

• Output is produced by a representative rm, according to the production function

Y = zF (K, N ) (4)

where Y is current output, z is current TFP, K is the current capital stock, and N is the
current labor input. The function F has all the properties we discussed in Chapter 4

• Constant returns to scale implies,

Y K
 
= zF ,1
N N

where Y
N is output per worker and K
N is capital stock per workers

• For simplicity, rewrite this equation as,

y = zf (k) (5)

where k is capital per worker, and f (k) is the per-worker production function dened as
f (k) ≡ F (k, 1)

• Some capital stock wears out each period. Assume the depreciation rate is some constant d,
where 0 < d < 1. Then, the capital stock changes over time according to

K 0 = (1 − d) K + I (6)

where K 0 is the future capital stock, K is the current capital stock, and I is the investment

Competitive Equilibrium

Now that we have the behavior of the consumers and rms, we can put the behavior together and
nd the competitive equilibrium.

• There are two markets that must clear in the current period

1. current consumption goods are traded for current labor

Labor supply is always N so the real wage will adjust so that the rm wants to hire N
workers
2. current consumption goods are traded for capital
If S is aggregate savings, the capital market is in equilibrium when,

S=I

• Because S = Y − C in this economy, write the equilibrium as

Y =C +I (7)

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 Plug in for I from Equation (6) and C from Equation (2)

Y = (1 − s) Y + K 0 − (1 − d) K

K 0 = sY + (1 − d) K (8)

Substitute in for Y from Equation (4).

K 0 = szF (K, N ) + (1 − d) K (9)

• It is often convenient to express Equation (9) in per-worker terms by dividing by N

K0 F (K, N ) K
= sz + (1 − d)
N N N

N0
Multiply the LHS by 1 = N0

K0 N 0 F (K, N ) K
0
= sz + (1 − d)
N N N N

K0 N 0 F (K, N ) K
0
= sz + (1 − d)
N N N N

k 0 (1 + n) = szf (k) + (1 − d)k (10)

• Then, divide both sides by (1 + n) in order obtain an equation that write next period capital
as a function of current period capital

szf (k) 1 − d
k0 = + k (11)
1+n 1+n
Equation (11) is the key equation of the Solow Growth model which summarizes the compet-
itive equilibrium

2 Steady State
• The Solow model predicts the the quantity of capital per worker converges to a constant, k ∗
[Figure 7.13]

• Then, in the long run it also predicts output per worker converges to a steady state y ∗ = zf (k ∗ )

 Given, s, z , and n, the real income per capita cannot grow in the long run
 Take y as a measure of standard of living
 There can't be any long run increase in standard of living under this situation (because
output per worker can only grow if capital per worker grows)

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 • Aggregates grow at a rate N = (1 + n)

K = k∗ N

Y = y ∗ N = zf (k ∗ ) N

I = sY = sy ∗ N = szf (k ∗ ) N

C = (1 − s) Y = (1 − s) y ∗ N = (1 − s) zf (k ∗ ) N

• In the Solow Model, growth in key macro aggregates are determined by exogenous labor force
growth when the savings rate, the labor force growth rate, and total factor productivity are
constant

3 Analysis of the Steady State

To analyze the steady state, start with Equation (11)

szf (k) 1 − d
k0 = + k
1+n 1+n
In steady state, k = k 0 = k ∗ . Therefore,
szf (k ∗ ) 1 − d ∗
k∗ = + k
1+n 1+n

(1 + n) k ∗ = szf (k ∗ ) + 1 − d

szf (k ∗ ) = (n + d) k ∗ (12)
Equation (12) solves for the steady state capital stock per worker, k ∗

3.1 Example

Suppose the production function is given by:

Y = zK α N 1−α

With this functional form, the per capita production function is given by:
α
Y zK α N 1−α zK α N 1−α K

= = α 1−α
=z
N N N N N
Or,

y = zk α

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 Therefore, given this functional form, the relationship between next period capital, k 0 , and
current period capital, k , is given by:
szk α 1−d
k0 = + k
1+n 1+n
In steady state, k 0 = k = k ∗ . Then, the steady state capital stock will be given by:
sz (k ∗ )α 1−d ∗
k∗ = + k
1+n 1+n

sz (k ∗ )α = (n + d) k ∗

k∗ sz
=
(k ∗ )α n+d
sz
(k ∗ )1−α =
n+d
1/1−α
sz

∗
k =
n+d

3.2 Increase in the Savings Rate

• Suppose the savings rate increases due to a change in consumer preferences, s1 → s2 , s2 > s1
• Consider the example in which Y = zK α N 1−α
• Steady state capital stock per worker, k ∗ , and output per worker, y ∗ are higher under the
increased savings rate
1/1−α 1/1−α
s2 z s1 z
 
k2∗ = > = k1∗
n+d n+d
α/1−α α/1−α
s2 z s1 z
 
y2∗ = z >z = y1∗
n+d n+d
• Aggregate capital stock, output, and investment are larger

K2 = k2∗ N > k1∗ N = K1

Y2 = y2∗ N > y1∗ N = Y1

I2 = s2 Y2 = s2 y2∗ N > s1 y1∗ N = s1 Y1 = I1

• Impact on aggregate consumption ambiguous even though aggregate output is higher, the
increase in savings rate could lead to a decrease in consumption

C2 = (1 − s2 ) Y2 = (1 − s2 ) y2∗ N ? (1 − s1 ) y1∗ N = (1 − s1 ) Y1 = C1

• The growth rates of aggregates do not change. Both grow at rate N = 1 + n which is constant
• However, it may take time to adjust and we will see a higher growth rate of these variables
as the economy moves between the steady states.

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3.3 Consumption per Worker and Golden Rule Capital Accumulation

• May want to used consumption per worker as a measure of welfare

• In this section, we will show there is a value of savings that maximizes consumption
• Steady state consumption per worker is:

c∗ = (1 − s) zf (k ∗ )

which is the dierence between output per capita and savings per capita
• Note that we know from the solution of the steady state,

szf (k ∗ ) = (n + d) k ∗

• So, we can write steady state consumption per worker as:

c∗ = zf (k ∗ ) − (n + d) k ∗
∗ which maximizes c∗ . Call this k ∗ the Golden Rule Quantity of
• There is a value of kgr gr
Capital Per Worker
• Find kgr
∗ by maximizing steady state consumption per worker

max
∗
c∗ = max
∗
zf (k ∗ ) − (n + d) k ∗
k k

The FOC is:

 
∗
∂f kgr
z ∗
− (n + d) = 0
∂kgr

Or,
 
∗
∂f kgr
z ∗
= (n + d) (13)
∂kgr
• Equation (13) says that consumption is maximized at the level of capital where the marginal
product of capital is equal to the population growth rate plus depreciation
Question: How can we achieve this level of capital per worker?
Answer: Yes. Find the savings rate, sgr , so that kgr
∗ is the solution to the steady state. s
gr is the
Golden Rule Savings Rate. If savings takes place at this rate, then in steady state the
current population consumes and saves the appropriate amounts so that, in each succeeding
period, the population can continue to consume this maximum amount per person.
The savings rate in the golden rule case will be:
 
∗ ∗
sgr zf kgr = (n + d) kgr

∗
(n + d) kgr
sgr =  
∗
zf kgr

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3.3.1 Example
Continue with the example above in which Y = zK α N 1−α
First, nd the golden rule quantity of capital per worker

max
∗
c∗ = max
∗
z (k ∗ )α − (n + d) k ∗
k k

Then, the FOC is:

 α−1
∗
zα kgr =n+d

1/1−α
αz

∗
=kgr (14)
n+d
Use this to calculate the golden rule savings rate
α/1−α 1/1−α
αz αz
 
sgr z = (n + d)
n+d n+d

αz
 
sgr z = (n + d)
n+d

sgr = α (15)
Then, consumption in the golden rule case will be:
α/1−α
αz
 α 
c∗gr = (1 − sgr ) z kgr
∗
= (1 − α) z (16)
n+d

3.4 Decrease in the Labor Force Growth Rate

• Suppose the labor force growth rate decreases, n1 → n2 , n1 > n2

• Consider the example in which Y = zK α N 1−α
• Steady state capital stock per worker, k ∗ , and output per worker, y ∗ are higher
1/1−α 1/1−α
sz sz
 
k2∗ = > = k1∗
n2 + d n1 + d

α/1−α α/1−α
sz sz
 
y2∗ = z >z = y1∗
n2 + d n1 + d
• Aggregate capital stock, output, investment, and consumption are larger

K2 = k2∗ N > k1∗ N = K1

Y2 = y2∗ N > y1∗ N = Y1

I2 = sY2 = sy2∗ N > sy ∗ N = sY1 = I1

C2 = (1 − s) Y2 = (1 − s) y2∗ N > (1 − s) y1∗ N = (1 − s) Y1 = C1

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3.5 Increase in Total Factor Productivity

• Suppose TFP increases z1 → z2 , z2 > z1

• Consider the example in which Y = zK α N 1−α

• Steady state capital stock per worker, k ∗ , and output per worker, y ∗ are higher
1/1−α 1/1−α
sz2 sz2
 
k2∗ = > = k1∗
n+d n+d

α/1−α α/1−α
sz2 sz1
 
y2∗ = z2 > z1 = y1∗
n+d n+d

• Aggregate capital stock, output, investment, and consumption are larger

K2 = k2∗ N > k1∗ N = K1

Y2 = y2∗ N > y1∗ N = Y1

I2 = sY2 = sy2∗ N > sy1∗ N = sY1 = I1

C2 = (1 − s) Y2 = (1 − s) y2∗ N > (1 − s) y1∗ N = (1 − s) Y1 = C1

=⇒ These examples show that increasing the savings rate, decreasing the population growth rate,
and increasing TFP can lead to increases in the standard of living. Increasing TFP is the only of
these that can be sustained in the long-run (savings rate hits an upper bound, population growth
rate hits a lower bound)